Who Funds the Federal Government?

In his much-maligned comments on the “47 percent,” Governor Romney, however inarticulately, raised an important question at the heart of this election: Who pays taxes into the federal government?

This question is important because President Obama’s economic platform is based on the premise that over the past decade tax cuts have only benefited the rich and a general theme of his campaign is that the rich are not paying their ‘fair share.” Of course fairness, like beauty, is in the eye of the beholder. Nevertheless, a review of who pays taxes today calls into question the factual basis of this theme.

When all federal tax revenue sources are included, all income groups pay some money into the federal government. But all federal tax revenues include payroll taxes. An important question is whether payroll taxes (e.g. Social Security taxes) should be considered as general revenues for the government or as “contributions” to a worker’s own retirement. According to the Social Security Administration, in an essay describing the history of Social Security:

“In the original act, benefits were to be paid only to the primary worker when he/she retired at age 65. Benefits were to be based on payroll tax contributions that the worker made during his/her working life. …

The significance of the new social insurance program was that it sought to address the long-range problem of economic security for the aged through a contributory system in which the workers themselves contributed to their own future retirement benefit by making regular payments into a joint fund.[ii]”

Thus, according to the Social Security Administration, the original intent of social security was for individuals to invest in their own retirement through mandatory “tax contributions.” Based on this definition, payroll taxes are not general revenues for the government. They are a system in which “the workers themselves contributed to their own future retirement benefit.”

The federal tax system has always been highly progressive, requiring higher income earners to pay a higher share of their income. The top 1 percent of taxpayers pay a significantly larger share of their income in taxes, as well as a significantly larger dollar amount. In fact, due to the recession, the gap between the average tax rates for the top 1 percent and to the bottom 20 percent of income earners has never been greater. The same is also true for the share of federal tax liability, or the share of total tax dollars paid into the federal government.

The Tax Breakdown

While the federal government levies dozens of taxes, the vast majority of tax revenues are raised from personal income taxes, payroll taxes, and corporate income taxes. Figure 1 shows the percentage of total tax revenues raised by tax source, based on data from the Office of Management and Budget (OMB).[iii]

Individual income taxes are the largest revenue source for the federal government, accounting for 40 to 50 percent of total tax revenues between 1987 and 2011. The next largest revenue source comes from payroll taxes (e.g., Social Security and Medicare taxes), which accounted for 32 percent to 40 percent of total tax revenues between 1987 and 2011.[iv] Corporate income taxes are the third largest tax source, accounting for 7 percent to 15 percent of total tax revenues between 1987 and 2011. Together, these three tax sources have accounted for a fairly constant 90 percent to 94 percent of all federal tax receipts between 1987 and 2011. The remaining revenues are raised by the scores of minor revenue sources, such as excise taxes and fees.

Figure 1

Federal Tax Revenues by Source as a Percentage of Total Tax Revenues

1987 through 2011

Tax Payments by Income Group

Data on individual income tax payments are available from the IRS Statistics of Income databases, which divides taxpayers into 5 broad groups (quintiles), based on income levels. The lowest quintile represents the 20 percent of households with the smallest household incomes. The highest quintile represents the 20 percent of households with the highest household incomes. The IRS data can also be examined for the highest 1 percent of income earners, and even the highest 0.1 percent of income earners.

Several recent studies have shown that around one-half of the population does not pay any income taxes. For example, the Tax Policy Center recently found that 46 percent of all households did not owe any federal income tax in 2011,[v] and a study by the Joint Committee on Taxation found that 51 percent of all households did not pay any income tax in 2009.[vi] The vast majority – but not all – of these households are from the lowest income quintile.

But, as Figure 1 illustrated, the federal income tax only raises around one-half of all federal revenues. A more complete picture of who pays federal taxes would also account for who pays the other taxes, including corporate income taxes, federal excise taxes, and federal payroll taxes. The Congressional Budget Office (CBO) provides these estimates on an annual basis – the latest are from 2009 – with the assumption that payroll taxes should be included. (Later on we will look at the numbers with payroll taxes excluded.)[vii]

The CBO methodology recognizes that all taxes – whether personal income taxes, corporate income taxes, excise taxes, or payroll taxes – are ultimately paid by people. Therefore, all taxes can be allocated to people based on their jobs, purchases, and assets. Using data from the U.S. Census and Internal Revenue Service, the CBO allocates the total tax revenues from these major tax sources to different income groups. Figures 2 and 3 summarize the CBO’s estimated average tax rates and share of federal revenues (federal tax liability), accounting for personal income taxes, corporate income taxes, payroll taxes, and federal excise taxes.

Figure 2

CBO’s Estimated Average Tax Rates

1979 – 2009

Average Tax Rate by Income Group Top 1% Average Tax Rate Premium

Relative to Bottom 20%

Figure 3

CBO’s Estimated Shares of Federal Tax Liability

1979 – 2009

Federal Tax Liability by Income Group Top 1% Tax Liability Premium

Relative to Bottom 20%

The estimated average tax rate is calculated by simply dividing the total federal taxes paid by the total before-tax income earned by each group. These are the average tax rates reported in Figure 2. The share of federal tax liability estimates the percentage of total tax revenues raised from each income group. For instance, the share of all taxes paid by the highest income quintile came to nearly 68 percent of all federal revenues, whereas taxes paid by the lowest income quintile accounted for less than 0.5 percent of all federal revenues. These are the Federal Tax Liabilities reported in Figure 3.

Figure 2 illustrates how the average tax rates for the bottom income quintiles declined slightly from the early 1980’s until the recession of 2007. For instance, the middle income quintile (households whose earnings are in the 40 percent to 60 percent range – the statistical middle class) paid an average tax rate around 19 percent in 1979. That is, for every $1.00 earned, households in the middle income earning group paid, on average, 19 cents to the federal government, including payments for Social Security.

Overall, for 1979, including Social Security payments, for every $1.00 earned:

The lowest income quintile paid 7.5 cents to the federal government;

The second lowest income quintile paid 14.5 cents to the federal government;

The middle quintile paid 19 cents to the federal government;

The second highest income quintile paid 21.5 cents to the federal government;

The highest income quintile paid 27.1 cents to the federal government; and,

The top 1 percent paid 35.1cents to the federal government.

The average tax rate for the lowest income groups consistently fell for the next three decades. The highest income groups saw a drop in the early 1980’s, but since then have seen average tax rates that are either flat or rising slightly. Additionally, the “targeted” tax reductions implemented in response to the current economic malaise have reduced the average tax rates on lower income groups to a much larger extent than upper income groups. Table 1 summarizes these impacts by comparing average taxes paid to the federal government, including Social Security contributions, in1979, 2007 and 2009. Even including Social Security contributions, higher income quintiles continue to pay vastly higher average tax rates than lower income quintiles.

The average tax rate of the top 1 percent, compared to the bottom 20 percent, can be seen in the right hand graph in Figure 2. Following the sharp drop in average tax rates for the top 1 percent in the early 1980’s, the average tax rate on this group has been slowly rising, relative to the average tax rate on the bottom 20 percent. In 1987, the average tax rate on the top 1 percent was 2.7 times greater than the average tax rate on the bottom 20 percent. The average tax rate for the top 1 percent continued to widen, peaking at 5.9 times the average tax rate of the bottom 20 percent in 2004. Following the recession, the difference, or gap between the average tax rate on the top 1 percent and the bottom 20 percent exploded. The sharp change was due to the large drop in the average tax rate on the bottom 20 percent. As of 2009, the average tax rate paid by the top 1 percent was 28.9 times the rate paid by the bottom 20 percent.

Figure 3 shows that similar patterns held true for total tax liabilities. The declining average tax rates on all income groups except for the highest has been accompanied by a declining share of federal tax liabilities. The total dollar taxes paid by the four lower income quintiles has been steadily declining as a share of total dollar taxes collected by the federal government. Since the share paid by the four lower income quintiles has been declining, the share paid by the highest income quintile has been growing. In 1979, the taxes paid by the top 20 percent of income earners accounted for 55.3 percent of all federal revenues. This percentage rose steadily over the next three decades. By 2009, tax payments from the wealthiest 20 percent of taxpayers accounted for 67.9 percent of all federal revenues – down slightly from the peak in 2008 of 69.2 percent.

A similar dynamic holds for the top 1 percent. In 1979, taxes paid by the top 1 percent of income earners accounted for 14.2 percent of all federal revenues. By 2009, taxes paid by the top 1 percent of income earners accounted for 22.3 percent of all federal revenues – down from the peak in 2006 of 26.8 percent.

As we can see, once all taxes (including Social Security/payroll taxes) are taken into account, all income groups do pay federal taxes. But again, the question is whether payroll taxes should be considered taxes given that they were designed to function as future retirement benefits.

Excluding payroll taxes, the bottom 20 percent of income earners have been, on net, facing a negative average federal tax rate –that is, when factoring out the money they pay toward a future benefit (or, in other words, treating payroll taxes consistent with the original intent of Social Security as retirement insurance) the bottom 20 percent of income earners actually receive money from the federal tax system rather than paying into it.

As stated above, there are sound financial reasons to not consider payroll taxes as a general revenue source for the government. As designed, Social Security tax revenues are deposited into the Social Security Trust Funds and collected in order to pay for the future retirement benefits of the workers who contributed the revenues. Therefore, every dollar collected in Social Security benefits is connected to a future Social Security expense in the future. And this connection between current government revenues and future government expenses differentiates payroll taxes from other general revenue sources. When the federal government raises $1 from personal or corporate income taxes, no future obligation is created. That dollar is free to be spent by Congress through the appropriation process. However, since payroll taxes do create future obligations (future Social Security payment to retirees) revenues from payroll taxes differ from other tax revenues and should be treated differently.

Excluding payroll taxes, the bottom 20 percent of income earners have been facing a net negative average federal tax rate. When factoring out the money they pay toward a future benefit (or, in other words, treating payroll taxes consistent with the original intent of Social Security as retirement insurance) the bottom 20 percent of income earners actually receive money from the federal tax system rather than paying into it. This is shown in Figure 4 and Table 2.

For example, the Earned Income Tax Credit (EITC) provides a refundable tax credit to low and moderate income working families. 2011, a single-headed household with two children and $20,000 a year in income would have had to pay around $2,000[ix] in federal tax. But the household would have been eligible for an Earned Income Tax Credit (EITC) which would have given them a refund of about $4,400,[x] meaning they would have received an extra $2,400, from the government.

Another way of looking at it is that the only money the bottom 20 percent of income earners pay into the federal government are Social Security payments, which are a form of forced savings. These payments are the reason why the bottom 40 percent of income earners still, on net, pays money to the government. But this burden is specifically linked to an expected benefit for the individual, rather than a burden that pays for the general operations of government and the larger benefit to society.

Figure 4

Estimated Average Tax Rates Excluding Payroll Taxes

1979 – 2009

Table 2 presents the average tax rate for all federal taxes excluding Social Security payroll taxes by each income quintile, along with the top 1 percent of income earners. Although there are some variations, excluding payroll taxes reduces the average tax rate across the bottom 80 percent of all income earners by approximately the same amount. The impact is slightly less for the top 20 percent, and the impact from excluding payroll taxes on the average tax rate for the top 1 percent is even less.

Apart from payroll taxes, the bottom 20 percent have been net recipients of tax revenues since 1994. That is, federal tax revenues have actually been a source of income for the bottom 20 percent of the income earners for nearly two decades. In fact, the bottom 40 percent of income earners have been net recipients of tax revenues since 2008, due to changes in the tax laws that were enacted in 2007.

The federal income tax system is actually a revenue source for the lowest income groups, due to various income tax credits (e.g., the Earned Income Tax Credit and the Making Work Pay Tax Credit implemented as part of the 2009 stimulus). Studies that examine the issue by income quintile show that the bottom 40 percent of income earners receive more money from the federal tax system than they put in.

By definition, the tax payments made to the bottom 40 percent of income earners are paid for by income earners in the higher income quintiles. And because the top 20 percent of income earners fund about 70 percent of all federal revenues, these tax credits can be seen as a wealth transfer (primarily) from the top 20 percent of income earners to the bottom 40 percent.

However, the bottom 40 percent of income earners are making contributions to the Social Security system. And these Social Security payments exceed the net tax payments the bottom 40 percent receive from the federal government. Because Social Security revenues differ from general tax revenues, combining these payments into one number obscures important information regarding the tax system.

In sum, when one asks “who pays the taxes that fund the federal government?” –the answer is the top 40 percent of income earners; because they fund 86 percent of total federal expenditures (the top 20 percent fund nearly 68 percent.) When you factor out social security payments, the households that earn the least in the US not only do not pay federal taxes, our tax system redistributes money from the top to provide them with a supplemental income stream.

[i]Wayne Winegarden, Ph.D. is a contributor to EconoSTATS at George Mason University, a Senior Fellow with Pacific Research Institute, anda Partner in the economic consulting firm, Arduin, Laffer & Moore Econometrics. Donald Rieck is Executive Director and Managing Editor of the Statistical Assessment Service(STATS) and EconoSTATS contributor.

[iv]Total taxes included in this category include: OASDHI (Social Security, Disability and Medicare receipts) and the railroad retirement equivalent (92.6% of total payroll tax receipts in 2011), other federal retirement receipts (employee share) (0.5% of total payroll tax receipts in 2011), and unemployment insurance receipts (6.9% of total payroll tax receipts in 2011).

One Response to Who Funds the Federal Government?

Thank you for providing this information. Media failed to grasp the real significance of Romney’s “47 percent” remark. He got pummeled, but no one asked either Obama or Romney as presidential candidates, “How do you make up for this shortfall in budgeting?”

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